Liability for breach of directors’ duties clarified

By Aaron Sherriff*

Few appeals are scheduled to be heard over five days in the Supreme Court of New Zealand. But this was never going to be an ordinary appeal of a civil matter.

At issue was whether a group of directors, including a former Prime Minister, were liable for the collapse of one of New Zealand’s largest construction companies in 2013 and, if so, how the compensation they are liable for should be calculated. In an ironic twist, the hearing was held in a building the company had built.

Mainzeal was well-known, building everything from large-scale residential developments to significant commercial projects. But, at the time of its 2013 collapse, it was said to owe more than $NZ110 million to creditors.

In August 2023 – more than 10 years after Mainzeal was put into liquidation – the Supreme Court released its decision in the liquidators’ claim against the former directors of Mainzeal (Yan v Mainzeal Property and Construction Ltd [2023] NZSC 113), upholding the Court of Appeal’s decision that the directors were liable for reckless trading and for incurring obligations without the reasonable belief the company could perform the obligation when required.

The Supreme Court also determined how damages should be calculated and decided on an amount of $NZ39.8 million plus interest accrued since 2013. The court decided one director, Richard Ciliang Yan, was liable for the full amount, but the other directors for only a portion ($NZ6.6 million each plus interest).

Background

Mainzeal was established in 1968. By 2004, it was wholly owned by a Bermuda-registered overseas company, Richina Pacific. The majority of Richina shares were held by a North American investment consortium that was primarily interested in investing in China, particularly in the leather industry. That investment group was represented by Mr Yan.

Mr Yan was a director of Mainzeal. Former NZ PM Dame Jenny Shipley became a director in 2004 and chaired the Mainzeal board. She was joined by Clive Tilby and Peter Gomm.

Over subsequent years, the parent company and the wider group conducted major acquisitions of leather and shoe companies in mainland China. The companies had substantial land use rights, including around Shanghai, which became very valuable property as that city expanded. Funds of about $NZ40 million were transferred from Mainzeal for Richina acquisitions. In other words, Mainzeal assisted the parent company to acquire substantial assets in China.

Manizeal was in a vulnerable position, and depended on informal expressions of support, mostly from Mr Yan, that it could rely on the wider group’s support.

By 2012, Mainzeal was experiencing significant cash flow difficulties. In particular, it had difficulties with a significant construction contract with Siemens. Several major leaky building claims were also being pursued against Mainzeal.

Mr Yan ultimately confirmed there was no capacity to bring cash equity from China to assist and Mainzeal went into liquidation in early 2013. Unsecured creditors were ultimately owed about $NZ110 million. The liquidators started a High Court proceeding against the former directors for the benefit of creditors. The High Court agreed the directors breached their duties, as did the Court of Appeal.

The Supreme Court’s approach

The Supreme Court reviewed the origins of relevant sections of the Companies Act 1993, noting that directors’ duties and the rights and interests of company creditors have their origins in common law and equitable principles.

Two sections of the Companies Act were at issue.

First, under section 135, a director must not let the business of the company be conducted in a manner likely to create a substantial risk of serious loss to creditors. The Supreme Court said “substantial” refers to the probability of loss to creditors and “serious” to the extent of that loss, and that those who extend credit to a company will generally not anticipate exposure to risk that goes beyond the usual vagaries of commercial life.

The court then held that an objective approach is required when determining whether a company’s business was conducted in a prohibited manner. The focus is on the reasonableness of a director’s actions, on the basis of the material they had or should have had, if exercising the required standard of skill, care and diligence.

Second, under section 136, a director must not allow a company to incur obligations to creditors when they do not believe, on reasonable grounds, that the company will be able to perform those obligations when required to do so. The Supreme Court said directors should not commit a company to obligations unless confident, on reasonable grounds, that they will be honoured. The court elaborated:

Specifically: does a director have reasonable grounds to believe the company will honour the obligations being incurred that will fall due in the medium-to-long term?
More generally: given the state of the company, does a director have reasonable grounds to believe any obligations entered into subsequently will be honoured?

Directors’ breach of duties

The Supreme Court was unimpressed with the Mainzeal directors’ actions:

Mainzeal had a history of being unable to accurately predict its future trading. It would have been appropriate for the directors to view forecasts “with a degree of healthy skepticism”.
Mainzeal’s future was vulnerable to the actions and decisions of a single man, Mr Yan, who represented the parent group of companies. He could be expected to act generally in accordance with the parent group’s interests.
A key factor in the directors’ willingness to continue to trade, notwithstanding poor trading results and persistent balance sheet insolvency, was their understanding that Mr Yan and the parent group would assist Mainzeal if asked. The directors relied on verbal and written assurances from Mr Yan and the parent company in which they agreed to provide sufficient financial assistance, as and when needed, to enable Mainzeal to continue operations and fulfil all financial obligations. However, the assurances were not contractually enforceable.
Because the loans Mainzeal had made to related companies were irrecoverable, and there was no enforceable obligation on the parent companies to provide financial assistance, Mainzeal was balance sheet insolvent from 2005.
Mainzeal’s board papers and minutes indicate an extremely operational focus and not much attention was being paid to broader strategic issues the company faced. The minutes showed no strategic “taking stock” of the kind expected of a board of a large construction company. In a similar vein, the directors made minimal effort to seek professional or expert advice. For example, there was a failure to take timely, external legal advice on the implications of the solvency issues the company was facing or on the directors’ duties.
From 2011 to late 2012, Mainzeal entered into four major projects that each involved the company incurring medium-to-long-term obligations. The way in which the directors allowed Mainzeal to trade exposed creditors to a substantial risk of serious loss. In particular, after January 2011, the directors had no reasonable grounds to believe Mainzeal would, in the medium-to-long term, be able to pay its debts. A separate threat to Mainzeal’s solvency came from several leaky building claims.

The Supreme Court found the directors breached their section 135 duty from January 2011 and their section 136 duty for the four major projects entered into after January 2011 and all obligations Mainzeal incurred from July 2012. The court calculated damages for “new debt” during that time at $NZ39.8 million plus interest, with Mr Yan liable for the whole sum and the other three directors each liable for a limited sum of $NZ6.6 million plus interest.

Some takeaways

Some key themes are explicitly and implicitly repeated throughout the Supreme Court’s decision that will interest directors, particular those of SMEs and in the construction industry:

Directors have a continuing obligation to monitor the company’s performance and prospects. There is a need to regularly “step back” and constantly review risk at the governance level.
The more complex the company, the higher the level of skill and diligence expected of a director.
The directors of an insolvent, or nearly insolvent, company are entitled to time to take stock of the situation and, for that purpose, to obtain professional or expert advice, for example legal or accounting advice. The assessment’s purpose is to identify whether there is a path forward for the company so the directors can be satisfied that trading on is unlikely to create a substantial risk of serious loss to creditors. For that reason, in the short term, trading while insolvent may be legitimate. The period of time for directors to take stock will be what is reasonable in the circumstances, including the complexity of the company’s affairs and the urgency of the situation.
A long-term strategy of trading while balance sheet insolvent is generally unacceptable. There may be circumstances in which it will be legitimate for a long-term strategy to be followed, particularly where there are assurances of support from a parent or sister company or third parties that can reasonably be relied on.
There is a need for boards to have diversity of thought and expertise, and it is important that independent directors bring “fresh eyes” and an external voice, particularly where there is a large shareholder or owner/director on the board.
Directors need to take a cautious, well-documented approach to a company’s operation and ensure they have comprehensive directors & officers’ insurance cover.

This is the final decision from the courts on Mainzeal, however, you may still hear more about this case. The Supreme Court reiterated the view expressed by the Court of Appeal that a review of the relevant provisions in the Companies Act 1993 is appropriate.

*Aaron Sherriff is a partner with Duncan Cotterill in Wellington, New Zealand.